Economic Growth Trend Analysis
Economic growth trend analysis is often used to formulate capital market expectations. The trend rate of growth is an important input when setting capital market expectations.
Some of the key considerations of economic growth trend analysis are the following:
- Forecasting returns with discounted cash flow models incorporate the trend rate of growth. The need to keep these forecasts consistent with long-term economic growth imposes discipline on the models. The trend rate of growth acts as an anchor for long-term bond and stock returns
- Higher trend growth rates may lead to higher stock returns assuming the growth is not already reflected in stock prices
- When we speak of higher trend growth rates, we mean the economy can grow at a faster pace before inflation becomes a major concern. This consideration influences monetary policy and the level of bond yields.
- Higher trend growth rates tend to generate higher government bond yields.
Overall, the trend rate of growth is relatively stable in developed economies. In emerging economies, the growth rate can be less predictable since those economies may be catching up with developed economies.
Modelling the economic growth rate
A simple model for forecasting the economic growth rate is the following:
- labor input, which is based on growth in the labor force and labor participation.
- growth in the labor force depends on population growth and demographics
- labor participation refers to the percentage of the population working and is affected by real wages, work/leisure decisions, and social factors
- capital per worker, which increases labor productivity
- total factor productivity, which is reflected in technological progress and changes in government policies.
High rates of growth in capital investment are associated with high rates of growth in the economy. However, these high growth rates are not necessarily linked to favorable equity returns. This may be the case because growth rates are already factored into equity prices.
An additional explanation is that the source of equity returns is related to the rate of return on capital. If the rate of growth of capital is faster than the rate of economic growth, return on capital may decrease and equity returns may become less attractive.
We discussed the basic considerations that an analyst should take into account when using economic growth trend analysis when formulating capital market expectations.